Abstract
The existing literature on the theoretical relationship between the rate of inflation and real stock prices in an economy has shown varied predictions about the long run effects of inflation on real stock prices. In this paper, we present some time series evidence on this issue using South African data, by applying the structural bivariate vector autoregressive (VAR) methodology proposed by King and Watson (1997). Our empirical results provide considerable support of the view that, in the long run real stock prices are invariant to permanent changes in the rate of inflation. The impulse responses reveal a positive real stock price response to a permanent inflation shock in the long run, indicating that any deviations in short run real stock prices will be corrected towards the long run value. It is therefore concluded that inflation does not lower the real value of stocks in South Africa, at least in the long run.
Highlights
Traditional macroeconomic theory suggests that the real value of equity investments should not be affected by changes in the inflation rate
The inflation rate series is computed by taking the first difference of the natural logarithm of the consumer price index, whereas the real stock price series is calculated as the natural logarithm of the nominal share price index deflated by the CPI
For the value lps = –0.05, we have a corresponding significant gsp value of approximately 12. This suggests that inflation decreases contemporaneously by 0.5 percentage points for each 10% increase in real stock prices, whereas the gsp of 12 implies that long run real stock prices increases by 12 percentage for each percentage point increase in inflation resulting from a permanent inflation shock
Summary
Traditional macroeconomic theory (assuming monetary super-neutrality) suggests that the real value of equity investments should not be affected by changes in the inflation rate This stems from the reasoning that nominal variables should have no influence on the long-run values of real variables. Among the studies that focus on African stock market is the study by Alagidede and Panagiotidis (2010), which employs parametric and nonparametric cointegration procedures to test for evidence of a positive long run relationship between stock prices and inflation. Robustness checks suggested by King and Watson (1997) and implemented by Rapach (2002) are applied in this paper by generating measures of the long run real stock price response to a permanent inflation shock for a range of assumed identifying parameter values.
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